Tag Archives: Central bank

El-Erian On Markets Balance Solvency, Growth and Liquidity

Another week has passed by and more ugly signs of how deep our economic troubles are have emerged. The only thing that keeps our financial house of cards from collapsing is the endless stream of money coming from the central banks – primary the US Federal Reserve and the European Central Bank (ECB). But doubts about the final outcome still persist.

“The health of the global economy, and that of markets, depends on the success of a series of medium-term handoffs between the public and private sectors – in growth, balance sheets and credit flows. This week’s data highlighted their complexity.”

Mohamed El-Erian 

In spite of the massive injection of money into the financial system by the central banks, key economic indicators continue to disappoint.  And by now, the central banks have painted themselves into a corner where there’s little else to do. The global economy is practically in state of stagnation – the next stage is depression…

Mohamad El-Erian at PIMCO is one of the top leaders who have managed to keep his cool and not lose his head throughout this whole mess so far.

He openly admits he does not have all the answers, but as usually he points to some key factors that we all should be aware of.

Here’s his latest commentary, as published by CNBC today:

“The health of the global economy, and that of markets, depends on the success of a series of medium-term handoffs between the public and private sectors – in growth, balance sheets and credit flows. This week’s data highlighted their complexity. Fortunately for investors, the valuation impact is being compensated by central banks‘ wide open liquidity spigots,” El-Erian writes.

And continues:

To counter disorderly private sector de-levering and avoid an economic depression, governments and central banks around the world have aggressively ballooned their balance sheets.

This has helped heal some private balance sheets but job creation has remained very anemic, income inequality has increased, and growth has been too weak to allow for the de-levering of the public sector (including fiscal deficits and central balance sheets which now vary in size from 20% of GDP in the US to 30% in Europe).

In the US, Friday’s disappointing GDP print for the fourth quarter was a reminder of the challenge, especially in view of a less-than-reassuring composition.

Consumer growth was limited to just 2% notwithstanding yet another decline in the savings rate to 3.7%, a level last seen at the end of 2007. Export growth also decelerated. Indeed, were it not for a surge in inventory, the economy would have probably succumbed to the drag from government components.

The extent of the growth challenge in Europe was highlighted by Friday’s higher than expected increase in Spanish unemployment (to an agonizing 22.9%).

Meanwhile several of the region’s governments, ECB, IMF and private creditors continued to squabble about how to allocate the inevitable losses on Greek debt.

In Portugal, another highly vulnerable economy, market measures of default risk reached record highs this week.

The longer such solvency and growth indicators continue to flash red in Europe, the more likely that capital will continue to flee; and the harder it will be to overcome the region’s debt crisis.

Dr. Mohamed El-Erian is CEO and co-CIO of PIMCO, the bond investment house.

Read the full post at CNBC.

Related by econoTwist’s:

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Qou Vadis, QE?

Ever since the first rounds of quantitative easing (QE) by the US Federal Reserve, I’ve raised questions about how sound and sustainable this form of monetary policy is? How big is the risk that the greatest economic experiment in modern history may eventually fail? More than three years later, I’m still not sure. The only thing I’m sure of, is that the need for extreme measures is greater than ever.

“It doesn’t matter whether new investment is financed by more government borrowing, quantitative easing or redistribution. What matters is growth.”

George Irvin

(Photo by freakingnews.com)

While Mr. Ben Bernanke in the USA is trying to figure out new and more creative ways to flow the financial system with money in order to kick-start the nation’s economy, European politicians are obsessing over new and creative austerity measures in order to save money and regain the union’s financial balance. But nothing seems to work. 

In 2008 I called for the launch of a so-called “Keynesian war” – but with a twist:

Instead of increasing public spending the traditional way, by investing in infrastructure like transport and housing or by upgrading public institutions like the military, I suggested to aim the financial “guns” at research and education, closing  the gap between the rich and the poor, and developing clean energy.

The “Keynesian war” was launched, all  right. But the ammunition was poured into the banks and other financial institutions who barely manged to save their own asses, in addition to dump the problems on their respective  national governments.

The financial crisis is currently well beyond the stage I regarded as a “worst-case-scenario” only two years ago.

So, where do we go from here?

One thing ought to be clear: It’s no longer a question of method – the only thing that matters is the result.

Honorary professor George Irvin at University of London makes a pretty good summary in his latest blog post at the EUobserver.com.

The Debt Trap 

“Europe is obsessed with the growing stock of public sector debt; fiscal austerity has become the watchword of our time. Little does it seem to matter that fiscal austerity means reducing aggregate demand, thus leading to economic stagnation and recession throughout the EU as all the main forecasts are now suggesting,” Professor Irvin writes.

Even the credit rating agencies are worried, as S&P’s downgrading of France and eight other countries shows. Whether it’s Angela Merkel or David Cameron speaking, public debt is denounced as deplorable, and all are told to get used to hard times.

As Larry Elliot puts it:

“The notion that economic pain is the only route to pleasure was once the preserve of the British public school-educated elite, now it’s European economic policy”.

In Britain, immediately after the general election, the Tory-led coalition decreed that in light of the large government current deficit, harsh cuts were necessary to win the confidence of the financial markets.

But although the current deficit was high, the stock of debt (typically measured by the debt/GDP ratio) was relatively low and of long maturity, the real interest rate on debt was zero (and at times negative) and, crucially,

Britain had its own Central Bank and could devalue. As Harriet Harman argued in June 2010, Osborne’s cuts were ideologically motivated. The aim was to shrink the public sector, and the LibDems—fearing a new general election—chose to go along with the policy.

In the euro zone (EZ), where a balance of payments crisis at the periphery has turned into a sovereign debt crisis, the German public has been sold the idea that if only all EZ countries could be like Germany and adhere to strict fiscal discipline, all would be well.

The ultra-orthodox Stability and Growth Pact (SGP) has now been repackaged under the heading of ‘economic governance’ under which Germany and its allies will vet members’ fiscal policies and impose punitive fines on those failing to observe the deflationary budget rules to be adopted.

Never mind the fact that indebtedness in countries like Spain and Ireland was mainly private, or that the draconian fiscal measures imposed on Greece have, far from reducing public indebtedness, increased it.

Is debt always a bad thing?

In the private sector, obviously not since corporations regularly borrow money for expenditure they don’t want to meet out of retained earnings, while most households aim to hold long-term mortgages.

Public debt instruments like gilts in the UK or bunds in Germany are much sought after by the private sector, mainly because such instruments are thought to act as an excellent hedge against risk.

Remember, too, that when a pension fund buys a government bond, it is held as an asset which produces a future cash stream which benefits the private sector.

So ‘public debt’ is not a burden passed on from one generation to the next.

The stock of public debt is only a problem when its servicing (ie, payment of interest) is unaffordable; ie, in times of recession when growth is zero or negative and/or interest rates demanded by the financial market are soaring.

The question is when is debt sustainable?

Sustainability means keeping the ratio of debt to GDP stable in the longer term.

If GDP at the start of the year is €1,000bn and the government’s total stock of debt is €600bn, then the debt ratio is 60%; the fiscal deficit is the extra borrowing that the government makes in a year – so it adds to the stock of debt.

But although the stock of debt may be rising, as long as GDP is rising proportionately, the debt/GDP ratio can be kept constant or may even be falling.

Consider the following example. Suppose the real rate of interest on debt is 2% (say 5% nominal but with inflation at 3%, so 5 – 3 = 2). That means government must pay €12bn per annum of interest in real terms. But as long as real GDP, too, is rising—say at 2% per year—there’s no problem since real GDP at the year’s end will be €1020bn.

Even if the government were to pay none of the interest, the end-of-year debt/GDP ratio would be 612/1020 or 60%; ie, the debt ratio remains unchanged.

By contrast, if real GDP growth is zero, the ratio would be 612/1000 = 61.2; ie, the debt ratio rises only slightly. 

The rule is that as long as the real economy is growing by at least as much as the real rate of interest on debt, the debt/GDP ratio doesn’t rise.

Moreover, this holds true irrespective of whether the debt ratio is 60% or 600%.

But there’s a catch.

In a modern economy, the public sector accounts for about half the economy.

If a country panics about its debt ratio and cuts back sharply on public sector spending, this reduces aggregate demand and may lead to stagnation or even recession.

When a country stops growing, financial markets decide that its debt ratio may rise and so become more cautious about lending and demand a higher bond yield (ie, interest rate).

The gloomy prophecy of growing public indebtedness becomes self-fulfilling. This is exactly the sort of “debt trap” which faces much of the EU and other rich countries. The way out cannot be greater austerity.

What works for a single household or firm doesn’t work for the economy as a whole. A household can tighten its belt by spending less, saving more, and thus ‘balancing the books’, but an economy cannot.

If everybody saves more, national income falls.

Of course, Germany and some Nordic countries can balance the government books because an export surplus offsets domestic private saving. But the Club-Med countries cannot match them.

When no EZ country can devalue, to ask each EZ country to balance the books by running an export surplus is empirically and logically impossible.

Even if all could devalue, what would follow is 1930’s-style competitive devaluation.

The way out of the ‘debt trap’ is the same as the way out of recession: if the private sector won’t invest, the public sector must become investor of the last resort.

It doesn’t matter whether new investment is financed by more government borrowing, quantitative easing or redistribution (some combination of the three would be optimal).

What matters is growth.

By George Irvin

George Irvin is a retired professor of economics and for many years was at ISS in The Hague. He is now honorary Professorial Research Fellow in Development Studies at the University of London, SOAS.

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IMF Director Christine Lagarde Sees “Crisis of Confidence”

There seems to be some kind of revival sweeping over Europe these days, with both economists, regulators and politicians suddenly starting to realize what so many have pointing out for several years: The global crisis is actually just getting started, the stimulus and the austerity measures are just not working and the financial markets has ditched most of what little confidence they once had in governmental and institutional leaders’ ability to solve basically systemic flaws in our economic system. Today, as the markets keeps tumbling, newly appointed IMF-boss, Christine Lagarde, is telling us that a “crisis of confidence” have aggravated the situation.

“The spectrum of policies available to the various governments and central banks is narrower because a lot of the ammunition was used in 2009.”

Christine Lagarde

“It is a combination of slow growth coming out of the financial crisis and heavy sovereign debt. Both fuel serious concerns about the capital and the strength of banks, notably when they hold significant volumes of sovereign bonds. Should banks experience further difficulties, further countries will be stricken. We have to break this cycle,” Mrs. Lagarde says in the interview with Der SPIEGEL. But when it comes to concrete solutions, she’s just as vague as any other politician. 

The journalists, Marc Hujer and Christian Reiermann, from Der Spiegel asks all the right questions.

But Mrs. Lagarde is an experienced politician, and her answers are exactly as precise or foggy as they need to be from the IMF point of view.

Here’s the first part of the interview:

SPIEGEL: Ms. Lagarde, the global economy is slowing, markets are volatile and banks have all but ceased lending each other money. Does the situation remind you of 2008 just before the investment bank Lehman Brothers collapsed?

Lagarde: Each moment in history is different from previous situations and it’s wrong to try to draw comparisons. At the International Monetary Fund, we see that there has been, particularly over the summer, a clear crisis of confidence that has seriously aggravated the situation. Measures need to be taken to ensure that this vicious circle is broken.

SPIEGEL: What does that circle look like?

Lagarde: It is a combination of slow growth coming out of the financial crisis and heavy sovereign debt. Both fuel serious concerns about the capital and the strength of banks, notably when they hold significant volumes of sovereign bonds. Should banks experience further difficulties, further countries will be stricken. We have to break this cycle.

SPIEGEL: What should be done?

Lagarde: When we look at the European situation, there has to be fiscal consolidation qualified by growth-intensive measures. In addition, there has to be increased recapitalization of the banks. Clearly, the two go together. The sovereign debt issue weighs on the confidence that market players have in European banks.

SPIEGEL: Don’t you think that your warning that €200 billion ($285 billion) might be missing in the balance sheets of European banks aggravates the situation of those banks?

Lagarde: In the course of our work on global financial stability, we are looking at the situation in Europe. We will publish the results of this work in a couple of weeks. More generally, we do see a need for recapitalization of European banks so they are strong enough to withstand the risks coming from sovereign borrowers and from weak growth. This is key to cutting the chains of contagion.

SPIEGEL: Is the world on the brink of a renewed recession?

Lagarde: We are in a situation where we can still avoid it. The spectrum of policies available to the various governments and central banks is narrower because a lot of the ammunition was used in 2009. But if the various governments, international institutions and central banks work together, we’ll avoid the recession.

SPIEGEL: At the moment, however, exactly the opposite would appear to be happening. Many governments have introduced austerity packages in order to make up for the vast expenditures made during the crisis. Is that wrong?

Lagarde: I wouldn’t pass general judgement on that because it’s going to be country-specific. For some countries, the path is fine and should continue as is. For others, some of the measures that have been taken are so strong, given the current deficit situation, that they can accommodate some relaxation — especially if the economy weakens further, and provided there is a clear medium-term consolidation path.

SPIEGEL: Do you consider Germany to be one of those countries which could do more to stimulate the global economy?

Lagarde: In the course of our annual country checks, our experts recently visited Germany. Their conclusion was that, under the circumstances, the fiscal consolidation path adopted by Berlin was perfectly fine.

SPIEGEL: For now.

Lagarde: Of course these things always depend on circumstances. Given Germany’s heavy reliance on exports, if demand weakens so much that it really changes the equilibrium, then it would need to be revisited.

SPIEGEL: By, for example, stimulating domestic demand?

Lagarde: Domestic demand is good for both the German economy and for the other economies surrounding Germany. I do think that domestic demand in Germany has improved since the time when I floated this idea as finance minister in France.

SPIEGEL: Given the economic climate, do you not think it dangerous when countries pass laws mandating a balanced budget, as France is considering?

Lagarde: It’s clearly a signal to market players. It shows investors the seriousness of the government’s commitment to the principle of balanced finances. The general intention behind it is good.

SPIEGEL: Would you like to see the US implement such a “debt brake” rule?

Lagarde: Each country must find the best way to signal to the markets that they are serious about public finances. The IMF has a lot of experience and we would be very happy to give a hand to those countries that actually are in the process of implementing a debt brake.

SPIEGEL: Do you think the austerity measures recently agreed to in the US go far enough?

Lagarde: Which ones do you mean?

SPIEGEL: The commitment, after weeks of disagreement about the debt ceiling, to cut federal expenditures by at least $2.4 trillion over the next 10 years.

Lagarde: Such long-term commitments are a good principle because they credibly signal an intention to reduce the deficit and consolidate public finances on a more stable course, for example in health care spending. It can indicate that a country will reduce the deficit in the medium term and yet still have enough room in the short term to put in place measures that will actually stimulate growth and help create employment.

SPIEGEL: Does the US need a new stimulus package?

Lagarde: We are in a situation of slowed growth and we have a confidence issue that culminated this summer with the downgrading of the US from its AAA status. As long as the US puts in place a credible medium-term adjustment plan, there is probably space at the moment to contain the short-term adjustment and take some of those growth-inducing measures.

Read part 2 of the interview with Chrisitine Lagarde at SPIEGEL Online:

“European Leaders Have Made Very Strong Commitments”

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